Why mortgage deduction may sail by fiscal cliff

WASHINGTON (MarketWatch) — As Washington battles over fiscal-cliff compromises, it’s likely that lawmakers will kick the can or at most make only small adjustments to one tax break that analysts say is ripe for reform: the mortgage-interest deduction.

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The popular tax break allows homeowners to deduct interest on the mortgage debt of first and second homes up to $1 million and the interest on debt from up to $100,000 on home equity loans or lines of credit. But critics say the enshrined deduction skews benefits in favor of wealthier home owners, and that there’s been inadequate thought on the break’s policy objectives.

The stakes are high: Phasing out the deduction could increase revenue by $215 billion through 2021, which would make a serious dent in achieving the kind of revenue that leaders including President Barack Obama and House Speaker John Boehner are seeking.

But there are better ways to support the economy, according to industry officials who say the break is of particular importance now given a still-fragile housing market. The National Association of Realtors, the heavyweight trade association, opposes any changes to the law, saying that most homeowners use the deduction at some point, and cutting the break would lead to a decline in home values of 15%.

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Louis Palmieri removes personal belongings from his home ahead of a mandatory evacuation prior to Hurricane Sandy in East Haven, Connecticut October 28, 2012.

There are various proposals on curbing the mortgage-interest deduction. Obama has proposed limiting the benefit from deductions (generally, not just the mortgage-interest one) for higher-income taxpayers. During the presidential campaign, Republican hopeful Mitt Romney also talked about capping tax deductions. The bipartisan Simpson-Bowles and Domenici-Rivlin plans offered ideas such as lowering qualifying debt to $500,000 and excluding second homes, or converting the deduction to a capped credit.

Some analysts say lawmakers may leave the deduction untouched.

“The most likely scenario is that we don’t do anything,” said Adam Looney, a senior fellow in economic studies at The Brookings Institution, a Washington think tank. “There’s a broad constituency. A lot of people who depend on it, homebuilders, home owners.”

“It’s very hard to do any serious negotiation on tax reform in such a short time period,” said Eric Toder, co-director of the Tax Policy Center, a joint project of the joint venture of The Brookings Institution and Urban Institute.

Letting the Bush tax cuts expire is the most achievable option in the near term, said Chuck Marr, director of federal tax policy at the Center on Budget and Policy Priorities.

“That’s something that could be easily done,” Marr said. “Once they take that first step, the next is when deductions come into play. Many of them are very poorly designed and could be improved, but proposals to eliminate them are unrealistic.”

If lawmakers do move quickly on deductions, certain proposals are less controversial than others. For example, Looney said, one could exclude interest on home-equity loans from the deduction.

“Similarly, you could end the deduction for second homes with the idea that you don’t need to be subsidizing vacation homes,” Looney said.

Lawmakers could agree to an overall cap on itemized deductions, Toder said.

Dean Baker, co-director of the Center for Economic and Policy Research, a Washington think tank, said a cap for mortgage debt of around $450,000 is likely being considered.

“That would allow the vast majority of mortgage interest in most places to be fully deductible. It is possible that they are discussing making it a credit, presumably around 15%, instead of a deduction, but I doubt the Republicans would go for that,” Baker said. “There are some more complicated plans that could be thrown out, but I think a cap is the most likely thing to go through. They can phase down to the cap over a period of three to five years to limit the hit.”

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